Understanding Intermediaries in Payment Systems — Introducing Liquidity to Law Students

So as I noted a few days ago, one of my annual rites of passage is returning to the University of Missouri each summer to teach Modern Payment Systems. (Its always interesting to hear different people recall what the course was called when they were in law school — commercial paper, negotiable instruments, Commercial Payments, but I digress). This year, I decided to do something I have not ventured to do — teach the class through an article that I am writing on the role of payment intermediaries in consumer transactions. (As an aside, I believe the material came across far more dynamic).

Each year, I introduce the course by starting with the central policies of liquidity and certainty as pillars of all payments systems. Students that have had an economics background know certainty as the legal cornerstone to efficiency — but fewer students understand what liquidity is beyond the pale of converting something to cash; they don’t for example understand that liquidity can mean enabling something with cash-like qualities. To explain liquidity (one of the central promises of negotiability) I turned the class into a mini-bazaar. As a condition of staying in the class they must barter something to me in exchange for a cup full of M&M’s. By exchanging goods, I tell them, we have established economic worth and created new wealth — I know my cup of M&M’s is worth a highlighter, bookmark, Lexis Flash Drive, or Starbucks card as the case may be. But, our economy has a problem — there is no certainty in the transaction. A cup of M&M’s might be worth a highlighter to one, a flash drive or Starbucks Card to the next person. The economy is far too personal to be effective as a predictive wealth creation tool.

So I suggest we create some established value — perhaps using M&M’s since everyone has some by now, there are several different types (colors) and people have differing amounts. After we vote about which colors should have the most value (blue for some reason always wins and brown never wins — we still apparently value beauty over quantity since this year I made sure that every cup had more browns than blues — at least when evaluating has no real consequences), we decide that for convenience sake it would be better to have a central depository to hold our M&M’s and can issue statements of value. After some prompting, we decide to forgo having to exchange the statements of value for M&M’s, and instead simply exchange the statements as having value in and of themselves — cut out the step of going to our M&M bank to collect our goods for later exchange.

So now, I ask the students in groups to consider the big question we have been building towards — if we are going to say that the paper is just as good as the things the paper represents, what kind of rules should be enforced to ensure that the paper (a) keeps its value; and (b) is accepted in the most places possible? From this year’s class, here are some of their responses:

Establish some guidelines in which people can know the paper is legitimate

Have the government back the paper used in transactions

Enhance the value of the paper exchanged for goods over paper that is merely cashed in

Create co-ops of merchants that promise to the bank that they will accept the paper regardless of who uses it for exchange

Insulate the market against forgeries by adopting standards of acceptance

These responses (amongst others offered) showed the intuitive reasoning that students can offer. For example, students deduced that paper would only maintain is value if it were easily discerned as legitimate — either through formalizing the medium or through an outside body guaranteeing their performance. Similarly, the students recognized that the paper could have value that varied according to the risk of the transaction — a principle idea behind discounting notes. Finally, the students recognized the impact that networks have in payments — an idea that I will flush out more later.

In my next post I will talk about the constructs of liquidity and certainty — namely longevity, efficiency, and confidence.